Recent Developments and Prospects

2. Economic performance has been affected by the ongoing global recessionary conditions as well as declining oil production and lower oil prices in the latter part of 2008. Non-oil economic activity is estimated at slightly below 5 percent in 2008, offsetting the decline in oil activity and allowing for overall real GDP growth of 4 percent. Declining oil production contributed to pressures on the external current account in 2007, as did FDI-financed imports for a new liquefied natural gas plant, but the current account deficit narrowed to 2 percent of GDP in 2008. Foreign exchange reserves rose to over 13 months of imports at end 2008.

3. Declining oil production has impinged on Yemen’s sound fiscal position and on medium-term fiscal sustainability. The overall fiscal deficit, which had been contained at about ½ percent of GDP in 2005 and 2006, swelled to over 5 percent of GDP in 2007 and 2008. To mitigate the impact of surging commodity prices on low-income families, the authorities increased wages, pensions, and social welfare transfers and intervened to increase the supply of basic food commodities in the first half of the year. In spite of efforts to contain other expenditures, lower oil revenues could not be offset by commensurate increases in non-oil revenues and expenditure reductions while preserving social cohesion. In the face of rising budgetary financing and imported inflationary pressures, the Central Bank of Yemen (CBY) maintained exchange rate stability and tightly controlled liquidity through selling Treasury bills and CBY certificates of deposit, as well as foreign exchange auctions. These measures were effective in slowing down growth in monetary aggregates and inflation, which surged to 25 percent in mid-2008, came down to 11 percent by year-end.

4. Yemen has been sheltered from the direct impact of the financial crisis but remains vulnerable to commodity shocks and to global economic activity. The banking system has low exposure to investments and financing through international credit markets and there is no domestic stock market. Inflationary pressures stemming from high imported inflation have seen a gradual reversal in recent months. A decline in regional growth could affect remittances and non-oil foreign investment, thereby increasing the dependence on official financing flows. The key challenge is to adjust to the sharp decline in oil production, lower budgetary oil revenue, and foreign exchange receipts. Liquefied natural gas production will help soften this adjustment somewhat for the next ten years, but the authorities are well aware of the need to bolster non-hydrocarbon activity.

Fiscal Policy and Debt Sustainability

5. The Yemeni authorities recognize the risks to public finances and external sustainability that have emerged since the end of the oil price boom. As oil prices began to decline in the latter part of 2008, measures were taken to compress expenditures including fuel subsidies by raising the price of diesel to industrial users, so as to contain the deficit to around 5 ½ percent of GDP, slightly below the 2007 level. The 2009 budget was originally formulated on the basis of a crude oil price of $55, but they have since prepared scenarios based on a crude price of $40 and $30. A cabinet decision was adopted in December 2008 that outlines cuts to a broad range of expenditure line items, reaching 50 percent of the budgeted amounts in some instances. These cuts, amounting to 1.3 percent of GDP, will be painful to bear and unpopular, particularly ahead of the April general elections. About one-half of the expected saving will be generated from a 13 percent reduction in outlays for costs of goods and services, while preserving priority programs such as security and hospital care. The remainder of the expenditure cuts will be attained through reductions in subsidies, bonuses and allowances and unclassified expenditures. The measures aim to limit the deficit to 8 ½ percent of GDP at an average crude oil price of $40 per barrel in 2009.

6. The authorities share the view that a sizable consolidation effort, in the range of 2 percent of GDP annually, will be needed to ensure fiscal and debt sustainability over the medium and longer term as oil revenues taper off. They are in broad agreement with the measures proposed that emphasize boosting non-oil revenue and trimming government expenditures. On the revenue side, they are considering reducing during 2009 the exemptions on the GST that were introduced in January 2007, and to raise the rate from 5 to 10 percent. They have submitted to parliament a tax simplification project that is intended to reduce the highest tax rate from 35 to 20 percent while eliminating exemptions to income and customs taxes—a project that would broaden the tax base while reducing the administrative burden on the private sector. They are also considering ways to contain the wage bill in nominal terms and to increase domestic fuel prices to align them with international prices—but these measures cannot realistically be introduced prior to mid-year.

7. The authorities concur with the conclusions of the debt sustainability analysis (DSA) which underscores the potential vulnerabilities of debt dynamics in Yemen. They recognize that the ratio of debt to GDP could rise rapidly if no measures are taken to contain a widening fiscal deficit. They note, however, that public debt remains relatively low and that a debt law is currently under discussion that will set ceilings for domestic, external, and overall public debt. Given the high risk of debt distress, the authorities are hopeful that all donors, and not only GCC countries, would be mindful of the need for a high degree of concessionality.

Monetary and Financial Sector Policies

8. Stability of the rial vis-a-vis the U.S. dollar has helped enhance confidence in the currency, reduce dollarization, and dampen imported inflationary pressure. The authorities consider the level of the exchange rate to be appropriate and welcomed the same conclusion in the staffs assessment. CBY officials intend to remain vigilant in monitoring and controlling excess liquidity through selling Treasury bills and CBY certificates of deposit, as well as foreign exchange auctions. In view of the decline in headline inflation to the target of 15 percent by end-December, the authorities reduced the benchmark interest rate on deposits from 13 percent to 12 percent in early February. If needed, they will consider raising reserve requirements and use Shari’a compliant monetary policy instruments.

9. The authorities consider developing a vibrant financial system to be a high priority. Over the past year, they initiated a number of reforms, including passage of a deposit insurance law, establishment of a deposit insurance corporation, raising banks’ minimum capital requirements, submission to parliament of a microfinance law, and relaxing limits on opening Islamic bank branches. They are committed to stringent enforcement of prudential standards and to address weaknesses in contract enforcement, which would encourage banks to expand their clientele.

Structural Reforms and Investment Climate

10. The Yemeni government will continue its efforts to further diversify the economy and promote alternative sources of growth and employment generation. In addition to the gas sector, there has been a concurrent focus on strategies to promote the development of the country’s tourism and maritime activities, to capitalize on the coastal location and cultural heritage. To encourage investments into these areas, they have undertaken a number of initiatives to strengthen the investment climate. Key among these are the establishment of a one-stop shop for investors, a new procurement law, and an active anticorruption authority; as well as a comprehensive review of the company and labor laws. Consequent to these efforts, Yemen’s ranking on the World Bank’s Doing Business report jumped from 113 in 2008 to 98 in 2009.

11. Intensified donor support will be critical in view of the significant immediate challenges and vast development needs. Donor support has been instrumental in helping to sustain the authorities’ reform efforts aimed at tackling problems of widespread poverty and limited institutional and implementation capacity. As highlighted in the donor briefing in Sana’a on February 7, 2009, the authorities are well cognizant of the need for drastic adjustment to bridge the gap between domestic resources and human and physical capital development needs. Donor support can soften the pace of adjustment and help bring about broader acceptance of the transformation.

12. Finally, I would like to convey the Yemeni authorities’ appreciation to the staff and management for the collaborative engagement with the Fund. They particularly appreciate staffs valuable policy advice during the Article IV mission and helpful technical assistance they continue to receive from the Fund. They look forward to continued dialogue on the policy priorities in the period ahead.